Posted by: Josh Kurlantzick on February 24, 2009by Good.comMao BucksBeijing should bankroll a new “global rescue fund” to help countries hit hardest by the economic collapse.

In the wake of the global financial crisis, most countries are looking to the United States to stabilize markets and prevent a second Great Depression. “Americans don’t have a choice, they must absolutely have a global plan,” the head of France’s central bank told reporters. But rather than asking Washington to save the day, the world should choose a wiser strategy—pass the buck east, to the only nation benefiting from the crisis, and the one with the resources to bail out the world.

For years, Western nations have criticized China for its state-controlled model of development, in which Beijing protects certain strategic industries, refuses to let its currency float on world markets, and uses capital controls in part to ensure its citizens save a high percentage of their incomes. “China is a manipulator [of its currency],” New York Senator Charles Schumer, a frequent China critic, charged at the Senate Banking Committee hearing last year.

Since the late 1970s, though, this strategy has brought China the fastest growth in modern history, and now Beijing’s decision looks even wiser than ever. Because of its currency restrictions, China’s renminbi cannot be attacked by speculators and traders. Because of its capital controls, it has amassed one of the largest pools of savings in the world, since its people have few options other than saving. If China’s economy cools down—it is still growing by 9 percent, even during the global crisis—the government can inject massive amounts of capital to bail out the Chinese economy.

While China saves, Western nations struggle to gain any traction against the global fiscal meltdown. And if their giant rescue packages fail—thus far they have failed to stop the wild market fluctuations—the American and European governments will eventually be tapped out, running such huge deficits they can no longer afford massive state interventions. The other major world economy, Japan, has little to contribute to the rescue either—it still has barely recovered from its own devastating crisis, during the 1990s.

That leaves China. With as much as $2 trillion in currency reserves—by far the most on earth—China could save the day. It could become a lender of last resort to distressed banks and other financial firms across the world, or could funnel some of its money to the International Monetary Fund, which helps stabilize debt-ridden countries. Beijing could even bankroll a large, new “global rescue fund” to help countries hit hardest by the crisis, an idea proposed at one recent world summit.

A rescue would show that Beijing’s model of development—one that doesn’t involve messy things like democracy—can stand up to the Western democratic gospel preached since World War II.

A Beijing bailout would not be pure altruism; it would benefit China greatly as well. By taking the lead, China would put itself in position to pick through Western financial firms and other companies for the best assets. Already, China’s state-controlled fund has invested in Morgan Stanley, and has started recruiting people to work for the Chinese fund as American investment firms lay off workers en masse. Beijing also has negotiated new deals with Russia, possibly providing at least $20 billion in loans to Russian petroleum firms in exchange for oil, a resource vital to China’s energy-hungry economy.

Bailing out the West also could prove the final capstone in China’s global ascendancy, signaling, like the United States’s dominance of the post-WWII globe, that Beijing has arrived as a power—and even has lessons to teach other nations. A rescue would show that Beijing’s model of development—one that doesn’t involve messy things like democracy—can stand up to the Western democratic gospel preached since World War II. And once shy of promoting its model, China now may be ready to play the leader. In recent years, Beijing has started touting its success to other nations through annual training programs for thousands of officials from across the developing world.

Some in Beijing already have begun crowing over this power shift. As one Chinese state media outlet put it, in slightly less diplomatic terms than some of the Chinese officials I’ve met: “The United States is no longer the omnipotent savior and global protector of American values.”

But passing the buck to Beijing would have benefits for other countries, too. By relying more on Chinese capital, Western countries would not have to run as large deficits, and could use their state funds for other desperately needed initiatives, like ensuring workers hurt by the crisis still have some form of health care or reforming retirement benefits, since most Western nations have aging societies. Many of these countries already have decimated their state treasuries: Between the $700 billion financial rescue package and the $787 billion stimulus bill, America’s deficit will run over $1.5 trillion this year.

Even better, passing the buck will help cement China into the international system, which would be an enormous relief for the United States and other Western nations. Right now, many Chinese leaders seem unsure whether Beijing should play nice with the world—by helping resolve the North Korean nuclear crisis, for example—or go it alone, as China has for decades, by continuing internationally frowned-upon activities like shipping arms to Zimbabwe even as Robert Mugabe’s government brutalizes its opposition. Many American officials I’ve spoken with fear that, in the long run, a go-it-alone China will become angrier and more aggressive, like Japan before WWII, with few links to the world to restrain it.

By investing in a global financial rescue, China could no longer go it alone; its fortunes would now be closely tied to the health of the world. A nation that has helped bail out, say, South Africa—a country hit hard by the global financial crisis—could hardly also continue backing Zimbabwe, where the ongoing political warfare destabilizes its neighbors by sending thousands of refugees streaming into South Africa. A nation investing all over the globe could no longer avoid joining the clubs of major powers, like the G-8 summit of industrialized nations, to which China does not yet belong. And a country that, eventually, might wind up using its massive savings to rescue much of America’s financial institutions would find it harder to, one day, turn around and attack the United States.

By DAN BILEFSKYPublished: February 23, 2009 PRAGUE — The owner of some of the Czech capital’s chic restaurants unveiled a novel approach this week to lure business clients to one of his upscale dining rooms: let diners pay what they like. The owner, Sanjiv Suri, hopes executives will not want to appear cheap to their guests when presented with a blank check after dining at the lunch buffet, laden with grilled vegetables instead of foie gras. Even if they pay nothing, he added, they will almost certainly return as paying customers.

“During an economic crisis you need to be creative,” said Mr. Suri, sipping pinot noir in a half-empty dining room.

Breaching the old adage that there is “no such thing as a free lunch” is just the latest tell-tale sign that the financial crisis has reached the Danube, even in a relatively resilient economy like the Czech Republic’s. As exports to Western Europe — its biggest market — begin to falter, companies are scaling back. Unemployment is starting to rise, hitting 6.8 percent last month, versus 6 percent a year earlier. The country’s gross domestic product is expected to contract by about 0.3 percent in 2009, the Czech National Bank said this week, after growing about 4 percent in 2008.

How bad it gets remains to be seen. Czech optimists say that they should fare better than countries to the east, which are far more dependent on loans from Western banks and have less developed economies. Indeed, the crisis threatens to widen the economic divide within Eastern Europe, as richer, well-run countries like the Czech Republic better withstand the downturn, leaving weaker peers further behind. “The disaster spotlight is now being pointed at east and central Europe,” said Gernot Mittendorfer, the Austrian chief executive of Ceska Sporitelna, a large Czech bank owned by the Erste Group of Austria.

“But panicked investors are wrongly lumping all of the countries in this region together, and the reality is that there is not widespread rot.”

The most vulnerable are the newer states. Moody’s Investors Service warned in a report last week that western owners of East European banks are coming under pressure to withdraw capital from countries already reeling from budget deficits and foreign borrowing. The countries most at risk, the report said, are the Balkan countries, Hungary, Croatia and Romania.

While Asian economies recovered fairly quickly from the 1990s financial crisis by exporting their way out of recession, the export outlook does not look promising. Demand for goods is plummeting almost everywhere in the world.

Here in the Czech Republic, the problem hit home last week after foreign guest workers, who filled manufacturing jobs during the boom years, were offered free airline tickets and a 500-euro allowance to go home.

Few economists expect the region to avoid the recession rippling around the world. Nonetheless, Mr. Mittendorfer said, panic is not justified. The financial perils in places like Ukraine, he said, are not inextricably linked with wealthier, better-managed economies like the Czech Republic, Slovakia or Poland, which are already in the European Union.

Indeed, while emerging European markets need to repay more than $400 billion in short-term debt this year, a recent UBS report noted that more than half this debt was held by relatively resilient economies like the Czech Republic.

Much of the alarm over Eastern Europe has been focused on Austrian banks like Erste, Raiffeisen and Bank Austria, which came to the region after communism fell, eager to profit from the heady appetite for consumption and credit. Today, Austria’s loans to the east amount to 70 percent of its gross domestic product. Though many Eastern European subsidiaries could scarcely survive without their parent banks, Austrian bankers and financial analysts said they are confident the banks can provide it.

Andreas Treichl, chief executive of the Erste Group, one of Austria’s top three banks, said in a telephone interview that Erste had no intention of retrenching. He said the bank remained profitable and had adequate capital to cover its foreign exchange risk, even in volatile countries likeRomania. “We will definitely not retreat,” he said.

Mr. Treichl pointed out that while many in the West were experiencing profound economic crisis for the first time in their lives, Eastern Europeans are more resilient, having lived through communism, dictatorship and 300 percent inflation. “People in this region are 10 times better equipped to cope with a crisis than spoiled investment bankers in New York,” he said.

Even if they are not and the trouble spots implode, economists and analysts here said they were confident that the European Union, the world’s biggest trading bloc, would find a way to come to the rescue rather than allow financial chaos to spread across the Continent.

Manufacturers are planning for the long haul.

Radek Spicar, a spokesman for Skoda, the Czech automobile maker, said the company had suffered a steep decline in orders from Western Europe, in particular Germany. Skoda has reduced its temporary workers to 800, from 4,000, and has shortened its work week to four days, from five. So far, it has not dismissed any of its 25,000 full-time workers

Germany’s stimulus package includes an offer of 2,500 euros to every person who scraps a car nine years or older and buys a new one, and that is bringing more Germans to Skoda showrooms, Mr. Spicar said. The Czech government is designing its own stimulus package as well.

The biggest casualty of the crisis in Eastern Europe could be unfettered capitalism, ardently embraced by countries that came out of communism. Thousands of people have taken to the streets in Poland, Latvia, Bulgaria and elsewhere, angry that their social safety net is tattered. In the Czech Republic, there was palpable resentment this week that Czechs were being punished for economic transgressions committed elsewhere.

Tomas Sedlacek, who served as an economic adviser to former President Vaclav Havel, noted that in the 1990s, the West lectured the former Eastern bloc about the need to privatize and deregulate. Now, the message emanating from Washington is to nationalize and to regulate.

“This crisis has turned the world upside down,” he said. “People here who argue that open markets are the solution to everything are no longer being taken as seriously.”

Twenty years ago in Eastern Europe, a broad wave of protests swept aside Stalinist regimes that at the start of 1989 had seemed firmly ensconced in power. In June, Solidarnosc won the parliamentary elections in Poland, and in October, Hungary adopted a bourgeois constitution. In November, the Berlin Wall was toppled along with the Stalinist regime in Bulgaria. The next government to fall was in Czechoslovakia, while in Romania, the Stalinist dictator Ceausescu was shot by a firing squad.

The movements that unleashed these political earthquakes had a broad but diffuse social basis. They were motivated by the desire for more democracy and better living conditions, but lacked any clear idea of how to achieve these ends. The working class, which constituted the overwhelming majority of the population, lacked any independent perspective. Decades of political suppression by the ruling bureaucracy and the perversion of Marxism by Stalinism had severed the working class from the traditions of genuine socialism.

Under these conditions, a minority took the initiative to restore capitalism. The Stalinist bureaucrats sided with them, proclaimed the “failure of socialism” and secured their privileges by appropriating large sections of the nationalised productive forces as their own private property. The majority of the population paid a high price. Social life throughout Eastern Europe is characterised by unemployment, mass poverty, the decay of infrastructure and health and education systems, and gross social inequality.

Now, 20 years after the overthrow of the Stalinist regimes, there are indications of a fresh wave of protests. In recent days, sharp clashes occurred in Latvia, Lithuania and Bulgaria.

On January 13, 10,000 gathered in the Latvian capital of Riga to protest against the flagrant incompetence and corruption of the government. Demonstrators threw snowballs and, according to the police, a few Molotov cocktails. The police responded with tear gas, made 126 arrests and injured 28 demonstrators.

A few days later, similar scenes took place in neighbouring Lithuania. After a trade union demonstration in the capital city of Vilnius, protesters tossed snowballs, eggs, bottles and stones at the country’s parliament. The police responded with tear gas and rubber bullets.

The European Union fears a chain reaction. The Financial Times wrote: “In Brussels there is growing concern that the public protests could spread across the entire region where many governments depend on narrow majorities or are based on shaky coalitions.”These concerns are entirely warranted. The international financial and economic crisis has massive implications for Eastern Europe. It is shattering not only its national economies, but also the ideological conceptions bound up with the restoration of capitalism in these countries.

Relative high rates of economic growth, foreign investment, entry into the European Union and the social rise of a middle class layer encouraged hopes that the economic and social situation would improve after an initial period of economic difficulties.

Now these illusions are being shattered. The international economic crisis has brutally exposed the parasitic and semi-criminal character of east European capitalism. The result of 20 years of capitalist “reconstruction” is a mountain of debts and the looming bankruptcy of entire states.

International concerns that made handsome profits by exploiting cheap labour in Eastern Europe are implementing mass redundancies as demand for their goods shrinks. Western European banks that made high returns in Eastern Europe are withdrawing their investments. And the ruling elites, who became fabulously rich through the privatisation of state assets, are now making the people pay for the crisis.

They are doing so in close collaboration with the EU and the International Monetary Fund (IMF). The protests in Latvia were a direct reaction to an IMF financial package that was tied to extensive austerity measures. It is expected that the Latvian economy will shrink in the coming year by at least 5 percent with a 10 percent increase in unemployment.

Twenty years of capitalist restoration have left nothing of lasting value or capable of withstanding the crisis. Western European concerns and banks have systematically ransacked Eastern Europe, and the native elites, acting as intermediary, have raked in their own share of the booty. Now finance capital is being withdrawn, leaving not only states, but many ordinary citizens as well, with a mountain of debt.

According to a report in the Austrian newspaper Kurier, 30 percent of the income of east European households is tied up with debt repayment. This percentage is even higher in Ukraine, Romania, Hungary and Slovenia. In the euro zone countries, the equivalent percentage stands at 10 percent.

National budgets are also massively indebted. The worst situation is in Ukraine, a country of 46 million. The country confronts bankruptcy and is only able to acquire new loans at horrendous rates of interests. Ukrainian government bonds are yielding a profit of 27 percent, and the currency is in free fall: the Hrywnja has lost 30 percent of its value in the last three months. Industrial production collapsed by 27 percent in the month of December.

In the meantime, western European banks are worried that they could be caught in the turbulence. Analysts currently regard Eastern Europe as one of the biggest risks for investors. Austrian financial institutions are particularly exposed. They have loaned €224 billion to Eastern European countries—the equivalent of 78 percent of Austrian GNP. But other European banks, including the Italian Unicredit, the German HypoVereinsbank (through its subsidiary Bank Austria), the French Société Générale and the Belgian KBC, are also heavily involved in the region.

Nine major banks have formed a lobby aimed at pressuring the European Union and the European Central Bank into supporting Eastern Europe. In particular, these banks are seeking guarantees for their own investments. The peoples of Eastern Europe will not see a cent of possible EU money. Instead, they will be forced to pay the bill for the bailout of Western banks through cuts in their living and social standards.

Western European bankers also fear that the gains of capitalist restoration have been lost. “Many of us have fought fifty years in order to free these countries from Communism and now that we have a free market system in the region we cannot leave them on their own,” was the comment by Herbert Stepic, head of the Austrian Raiffeisen International to the Financial Times. His bank played the leading role in assembling the lobby of nine banks.

The working class in Eastern Europe must draw the lessons from 1989. At that time, the advocates of capitalist restoration were able to prevail because workers lacked their own independent programme. The result is the current catastrophic situation.

At the time, the International Committee of the Fourth International issued strong warnings about the dangers of capitalist restoration. “The working class has not overthrown [the heads of the GDR] Honecker, Mielke, Krenz and the entire Stalinist Mafia in order to hand over the levers of production to Daimler, Thyssen and Deutsche Bank, the same capitalist interests which organised two World Wars and set up concentration camps for the workers.” wrote the Bund Sozialistischer Arbeiter (today the German Socialist Equality Party) in a programmatic statement of February 1990.

We opposed the infamous lie that declared that Stalinism was the inevitable consequence of socialism: “The history of Stalinism is the history of the greatest crimes committed against the working class—all in the name of socialism…. The collapse of the regimes in Eastern Europe has refuted not only Stalinists but also all anti-communists: what has failed is not socialism but Stalinism.”

We called for the defence of nationalised property and for its organisation under the democratic control of the working class. “The production facilities which were erected with great sacrifice by the working class cannot be left to the whims of the capitalists. State property must be cleansed from the control of the parasitic Stalinist caste and placed at the disposal of the working class…. Workers councils must assume control over the economy and democratically reorganise the planned economy from top to bottom in order to meet the demands of producers and consumers.”

Finally, we emphasised that these aims could only be achieved through the unified action of the international working class: “Capitalist restoration in Eastern Europe will have drastic consequences for the working class in Western Europe, allowing the capitalists to utilise cheap layers of qualified workers in the east to massively increase the exploitation of workers in the west…. The current situation poses more urgently than ever the task of uniting workers across all borders in a combined struggle for the overthrow of capitalism and Stalinism.”

This perspective is of utmost importance today. The unification of the European and international working class in the struggle for a socialist programme is the only progressive alternative that can prevent Europe from once again being plunged into war and barbarism as was the case in both 1914 and 1939.

BERLIN: New members of the European Union in Central and Eastern Europe have – so far – avoided much of the upheaval caused by the crisis of confidence in the global financial system.

Although consumer spending was falling and growth rates were declining in the Czech Republic, Poland, Slovakia, Slovenia and, particularly, in Estonia, analysts said the trends were not related to the banking turmoil spreading across the Continent.

“It is remarkable how little impact the crisis has had on the region as a whole,” Erik Berglof, the chief economist of the European Bank for Reconstruction and Development, said during an interview. The bank was established in 1991 after the collapse of the communist system to help countries in Eastern and Central Europe make the transition to market economies.

“The interesting question to ask is why the region has not been hit more than it has,” Berglof said.

One reason is that while most countries in the region opened their banking sector to foreign banks when they were preparing to join the European Union in 2004, they also strengthened their regulatory and supervisory processes.

“The presence of foreign banks in the banking system has managed to smooth the liquidity impact of the crisis,” Berglof said.

“What many of the banks in Western Europe did, they went for lending to Eastern Europe,” he continued. “In general, they had very little exposure to the subprime lending instruments that have been so disastrous for U.S. banks.”

The share of credit that comes from these banks has been high.

“Between 60 and 80 percent of the banking sector assets are controlled by foreign banks,” Berglof said.These domestic banks were initially run as independent subsidiaries. Now they have become much more integrated with their parent banks.

“In which case, if there was any kind of spillover, if the foreign banks in these countries were in some kind of difficulties, that would be a serious concern,” Berglof cautioned.

Some foreign banks that did buy into banks in Eastern Europe, like UniCredit of Italy, are now facing serious liquidity problems at home.

So far, UniCredit’s problems have not spilled over into Poland, said Maciej Krzak, a macroeconomic specialist at the Center for Social and Economic Research in Warsaw.

“The banks in Poland have been extremely profitable because they focused on lending and had strict credit standards,” Krzak said. “These banks were not dabbling in the subprime mess.”

The small and immature stock markets in Eastern Europe have been an advantage, too.

“Exposure by these stock markets to the world economy is relatively small,” said Vasily Astrov, an East European specialist at the Vienna Institute for International Economic Studies.

And yet, growth rates and consumer spending are declining across the region for reasons that Astrov said were domestically driven and, depending on the country, included higher interest rates, inflation or efforts to curb the budget deficit.

The International Monetary Fund reported Wednesday that Eastern Europe’s slowing economies faced growing risks from the global credit crunch, but that much of the region would post faster growth than Western Europe in 2009.

“The policy challenge is how to engineer a soft landing” while keeping the region on track toward Western European living standards,” the IMF said.In Poland, inflation and high interest rates have made its currency, the zloty, stronger against the euro and the dollar. As a result, exports, which are the driving engine of Poland’s economy, are slowing.

Growth this year is expected to fall to 6 percent, from 7 percent in the previous year.

The European Bank for Reconstruction and Development has estimated that growth across Central and Eastern Europe this year will average 4.7 percent, in contrast to 5.9 percent last year.

The bank said the slowdown reflects anti-inflationary tightening of monetary policies and the expected decline in exports.

In Slovakia, the central bank revalued the currency in May by 17 percent to achieve parity with the euro, which Slovakia will adopt next year. That has fed inflation and slowed exports.

February 25, 2009

Tyler Cowen, Princeton PaperbackAll things considered, tt was quite a relief that I got out of 2 rounds of the core exams and got back to my own schedule. This book is the first thing I read. Here, “destruction” is that of ethos, or special feel or flavor of a culture; “creative” is that of culture making process. The book discusses favorably to support cosmopolitanism, trade, and wealth as the main process through which mankind create diverse cultural values (clearly, diversity is meant to be a good thing for an economist – the more choices you have the better decision you make). Though the points are clearly stated, with quite convincing arguments, I don’t licreake the book for it is not colorful enough. There is none of such cosmopolitan feeling that the book is supposed to argue for.That said. I learn imporatnt lessons from the book. At least one point to take home:

… we have seen that trade supports diversity within societies, but party because cultural creators do not hold fully cosmopolitan attitudes. Cosmopolitan attitudes, if held fully and consistently, would defeat the cosmopolitan end of diversity and freedom of choice. In similar fashion we can say that the stock market operates with a relative degree of efficiency only because many investors – probably most investors – believe in its efficience and thus spend time trying to find bargains.

Examples of non-cosmopolitan or anty-diversity behaviors are scattered throughout the book. Most notably, the author cites the clustering of the movie industry, especially that at Hollywood:

For better or worse, Hollywood strives to present the unversal to global audiences. As Hollywood markets its films to more non-English speakers, those films become more general. Action films are favored over movies with subtle dialouge… Furthermore, Hollywood’s universality has, in part, become a central part of American national culture. Commercial forces have led America to adopt “that which can be globally sold” as part of its national culture. Americans have decided to emphasize their international triumphs and their ethnic diversity as parts of their national self-image. In doing so, Americans have, to some extent, traded away their particularist strands of their cultures for succees in global markets.

This is an example among many that exemplify that by imposing a “national” or sometimes provintial, anti-diversity identity, cultural creators are in fact creating diversity for the world. The creation and destruction of ethos go hand in hand, argues the author, and sometime which kind of diversities are good for the world is hard to discern.At a personal level, this lessons stresses the need for individuals to on the one hand open their minds to learn from other “culture” yet on the other hand enrich their own “ethos” that unique feel, value and belief over their curcumstances. Such an enrichment can clearly be enhanced by knowledge. More importantly, however, it must be done through constantly improving consumption habit of cultural products such as literature, music, fine arts,… or simply the art of dealing with other people.

CHINA is being cast as the villain once again. By holding its exchange rate artificially low, it is stealing jobs and causing the United States to run a huge trade deficit. Beijing must therefore be forced to revalue the yuan. These are the arguments behind an increasingly protectionist mood in Washington. Yet they are largely flawed. A stronger Chinese currency would not much reduce America’s trade deficit. Indeed, the irony is that China, not America, has more to gain from setting the yuan free. Without a more flexible exchange rate, there is a growing risk that China’s sizzling economy will boil over.

America’s anger at China is clearly growing. In February it filed a complaint to the World Trade Organisation (WTO) against Chinese export subsidies. In late March the Department of Commerce announced tariffs of 10-20% on glossy paper imported from China, to offset the impact of alleged government subsidies. This reversed a 23-year-old policy of not imposing countervailing duties on a non-market economy. Then in early April the Bush administration filed two more complaints: one on Chinese pirating of DVDs and CDs, and the other over restrictions on the sale of foreign films and music in China.

Although by themselves these actions are trivial, together they point to an increasing appetite for tougher action against China. The Bush administration is under increasing pressure, particularly from Congress.

Congressmen complain that the so-called China-US Strategic Economic Dialogue (a series of high-level talks between the two countries launched last year by Hank Paulson, the treasury secretary) has so far failed to produce results. The recent deterioration in trade relations does not bode well for the next meeting, which begins on May 22nd. Many commentators now reckon that Congress will inevitably pass some kind of China-bashing legislation later this year. A sharp economic slowdown in America as a result of the collapsing housing market would make this even more likely.

The biggest risk comes from measures linked to China’s supposed exchange-rate misalignment. The infamous Schumer-Graham bill, which proposed a 27.5% tariff on all Chinese goods to offset the yuan’s alleged undervaluation, was withdrawn last year. But the two senators behind it are working with others on a new WTO-compatible version that could soon appear. Although the new bill is unlikely to include across-the-board tariffs, it could have sharp teeth.

Meanwhile, the target of all this hostility looms ever larger: China’s trade surplus with America increased to $233 billion last year, accounting for almost 30% of America’s total deficit. China’s total current-account surplus reached an estimated $250 billion, or 9% of GDP, up from only 1% in 2001. Worse still, in the first four months of 2007, its trade surplus jumped by 88% compared with the same period in 2006.

The making of myths

China officially abandoned its decade-long policy of pegging the yuan to the dollar in July 2005. Since then it has risen by only 8% against the greenback. Because the dollar itself has weakened, the yuan’s trade-weighted exchange rate has barely budged. In real trade-weighted terms it is about 10% cheaper than at the dollar’s peak in 2002. As a result, it is not just the usual protectionist suspects that demand action, but many mainstream American economists are now calling on China to revalue by 20% or more. Yet the standard arguments for a revaluation are based partly on a series of myths.

The first myth is that there is overwhelming evidence that the yuan is grossly undervalued. China’s large bilateral trade surplus with America proves nothing. It largely reflects Asia’s changing supply chain. Much of what America buys from China today once came from Japan, South Korea and Taiwan. China now imports components from these countries, assembles them and exports the finished goods to America. Knock out these and America’s bilateral deficit with China shrinks by more than half. Even so, China’s overall current-account surplus is also huge. The surge in its foreign-exchange reserves, to over $1.2 trillion, also suggests that the yuan is undervalued: without those massive purchases of dollars, the currency would have risen.

However, not all economists agree that the yuan needs to be sharply revalued. At one extreme is Morris Goldstein, of the Peterson Institute for International Economics, who argues that the yuan is undervalued by 40% or more against the dollar and should immediately be revalued by 10-15%. In the other corner many highly respected economists, including Robert Mundell, an economics Nobel prize-winner, and Ronald McKinnon, of Stanford University, strongly argue against a big appreciation of the yuan.

The devil to measure

Economists find it devilishly hard to define the “correct value” for a currency. On purchasing-power parity (PPP), the yuan is clearly undervalued against the dollar. Perhaps by as much as 50%. But PPP is not useful for determining the optimal exchange rate between two countries of such different levels of income. It is natural for average prices to be lower in poorer countries because wages are lower. As countries get richer and their productivity rises, their real exchange rates appreciate. And although the depreciation in the yuan’s real trade-weighted value since 2002 looks perverse, this follows a real appreciation of 50% between 1994 and 2001 (see chart 1).

A study by two IMF economists, Steven Dunaway and Xiangming Li, found that estimates for the undervaluation of the yuan ranged from zero to nearly 50%, depending on which method was used. Another recent study, by Yin-Wong Cheung, Menzie Chinn and Eiji Fujii, concluded that using conventional statistical methods it is hard to prove that the yuan is much undervalued. Such uncertainty may partly explain why America’s Treasury Department has so far ducked labelling China as a currency manipulator in its twice-yearly report to Congress. Another reason is that it is loth to give ammunition to the protectionist lobby.

Myth number two is that the sharp increase in China’s trade surplus is due to an explosion in cheap exports. Until 2004 China’s surplus was relatively modest, but it soared over the next two years (see chart 2). Jonathan Anderson, chief Asia economist at UBS, points out that export growth actually slowed between 2004 and 2006 (see chart 3). The main reason for the bigger trade surplus was a sharp slowdown in the annual real growth rate in imports, from more than 30% in early 2004 to less than 15% last year.

The entire increase in China’s trade surplus since 2004 has come from trade in heavy industrial materials and equipment. China used to import increasing amounts of steel, aluminium, chemicals and machinery, but import growth collapsed after 2004 when the government started to tighten policy, causing a sharp slowdown in construction, one of the biggest importers of machinery and materials. At the same time China continued to invest heavily in metals and equipment, creating substantial excess capacity, so import growth remained relatively weak last year. Mr Anderson argues that imports should recover as overcapacity is used up.

The third fallacy is that imports from China destroy jobs and harm the American economy. It is hard to see how China can be blamed for job losses when America’s unemployment rate (4.5%) is close to its lowest for decades. Trade with China may affect the composition of jobs in America, but it has little impact on total employment. It is true that some workers are harmed by trade with China, just as there are some losers from all international trade. But the American economy overall is better off, so in theory there is ample room to compensate any losers.

Trade with China helps, not harms the average American. Thanks to imports from China, prices are lower and real incomes higher. Commentators often refer to the “cheap” yuan as being an unfair subsidy for Chinese exporters. But it is a moot question who exactly is subsidising whom. Not only do cheap imports subsidise American consumers, but China’s large purchases of Treasury bonds also hold down American interest rates, thereby subsidising home buyers. Suppose that overnight the yuan rose by 30%, what would happen? American interest rates would rise as China needed to buy fewer Treasury securities and prices at Wal-Mart would increase. If consumer spending and imports then collapsed, this would certainly reduce America’s trade deficit, but in a much more painful way than most Americans have in mind.

Wishful thinking

The biggest myth of all is that a revaluation of the yuan would greatly reduce America’s trade deficit. The real cause of the deficit is that Americans spend too much and save too little. This means that the country has to import surplus savings from abroad by running a current-account deficit. If a stronger yuan did not cause Americans to save more, it would do little by itself to reduce the trade deficit.

Another reason why even a big rise in the yuan would do little to reduce America’s deficit is that there is little overlap between American and Chinese production, so American goods cannot replace Chinese imports. Instead, other countries, such as Indonesia and Vietnam, would probably replace the Chinese. Shifting purchases to higher-cost producers amounts to imposing a tax on American consumers, says Stephen Roach, chief economist of Morgan Stanley.

Even where America and China do compete, as in electronics, the high import content of China’s exports blunts the impact of exchange-rate movements on export prices, because a rise in the yuan reduces input costs. About half of China’s exports consist of goods that have been assembled from imported components. And domestic wages and materials account for about 30% of the cost of those re-exports. Mr Anderson estimates that a 10% rise in the yuan would increase average export prices by only 3-5%.

If a yuan revaluation encouraged other Asian economies to follow suit, the impact on America’s trade deficit would be larger, but still modest. If a 10% revaluation of the yuan were matched by all other Asian currencies, the dollar’s trade-weighted index would fall by 4%. Yet, the 19% decline in the dollar’s trade-weighted index since early 2002 has failed to trim the deficit.

None of this means that a yuan revaluation leaves America’s trade deficit unchanged, simply that any change would probably be small. Nouriel Roubini, of Roubini Global Economics, finds evidence that China’s trade balance is affected by movements in its exchange rate: the yuan has fallen sharply against the euro since 2002 as a result of the dollar’s decline, and China’s exports to Europe have consequently grown at a faster rate than its exports to America. A stronger yuan might therefore curb China’s exports to America, but America’s deficit would continue to loom large if imports from China were simply replaced by those from elsewhere.

Chinese whispers

Many of the arguments heard in America in favour of a big revaluation of the yuan are flawed or at least exaggerated. However, many of the arguments used in Beijing for why a revaluation would endanger China’s economy are equally suspect. For instance, the common claim that a big jump would seriously harm China’s growth and employment contradicts the argument (also favoured by Beijing) that an appreciation would have little effect on China’s trade surplus with America.

Or take another popular line of defence: it is often asserted that China cannot afford a more flexible exchange rate until its dodgy banking system is reformed and strengthened. Eswar Prasad, an economist at Cornell University, says this argument has it completely backwards. The distortions caused by today’s rigid exchange-rate regime may themselves be the biggest threat to Chinese financial stability. A sound banking system requires an independent monetary policy, which uses interest rates rather than blunt directives, to guide credit. And a country cannot control its monetary policy unless it accepts a more flexible exchange rate.

By tying the yuan closely to the dollar, China has been forced to hold its interest rates lower than is prudent: higher rates would attract more “hot money” from abroad, putting upward pressure on the currency. The real rate of interest paid on bank deposits is negative and lending rates are far too low for such a fast-growing economy. Cheap money results in excessive bank lending and poor investment decisions, which could lead to an increase in non-performing loans. Excessively low interest rates are also fuelling stockmarket and property bubbles.

News that China’s real GDP surged by a breathtaking 11.1% in the year to the first quarter and that consumer-price inflation had risen to 3.3% in March (it eased to 3% in April), stoked fears that the economy is out of control. But concerns about overheating in the usual sense of excess demand are exaggerated. China’s widening current-account surplus and its strong investment imply excess supply. Excluding food, the inflation rate is only 0.9%. Instead, the real concern is that excess liquidity, as a result of the surge in foreign-exchange reserves and low interest rates, is flooding into shares (see article). Households are withdrawing money from low-yielding bank accounts to bet on the stockmarket. China needs much higher interest rates to cool its asset markets. To regain control over its monetary policy China needs to let the yuan rise.

A revaluation could also help the government succeed in shifting the balance of growth away from investment and net exports towards consumption. A stronger exchange rate would boost consumers’ purchasing power, allowing them to buy more foreign goods. Excess saving in China is as much to blame for global imbalances as inadequate saving in America.

Most of the increase in saving has come from Chinese companies, which are earning record profits. But household saving is also kept high by the poor public provision of health, education and pensions. Partly as a result, consumption accounts for an unusually low share of GDP.

The good news is that the mix of growth is starting to become more balanced: over the past year, investment has slowed while retail sales have quickened, rising by 15.5% in the year to April. In other words, consumer spending is now growing faster than GDP. Dragonomics, a Beijing-based research firm, estimates that consumption rose from 37% to 40% of China’s nominal GDP growth in 2006 and is set to rise again this year.

The stronger growth in Chinese consumer spending has got much less attention in America than the sharp increase in the country’s trade surplus. The contribution of net exports to China’s growth has increased so far this year. However, the near doubling of its trade surplus in the first four months of the year was probably a one-off, because firms brought forward their shipments so as to avoid an expected reduction in export-tax rebates. Exporters are also thought to be overstating their export revenues in order to dodge capital controls and bring in foreign money to invest in Chinese assets. If so, the trade surplus should stabilise in coming months.

In the long run, stronger domestic consumption could trim China’s trade surplus. The government can encourage this by spending more. Its spending on health care and education rose by an average of 50% last year and it is budgeted to rise by more than 60% this year—but from such low levels that it could take years to increase social spending by enough to encourage households to save a lot less. Meanwhile, a stronger yuan would help to rebalance the mix of China’s growth.

Mirror image

This turns the whole debate about China’s exchange-rate policy on its head. It is China that has the most to gain from allowing the yuan to rise. If the spat between America and China were to ignite protectionism or financial instability, it could endanger the whole world economy. All the more foolish, therefore, that economic relations are based on misperceptions on both sides. America needs to stop making China a scapegoat for the failures of American policy. Only if it gets its own economic house in order, by boosting domestic saving, will its “advice” to Beijing seem credible. Likewise, China has no right to criticise American policy when its own economy remains unbalanced.

America is right that China needs to revalue, but for the wrong reasons. And arguing that a revaluation helps America’s economy makes it less likely that Beijing will act. Moreover, if George Bush foolishly slapped harsh trade sanctions on China, America’s economy would be the biggest loser. Likewise, China is foolish to resist a more flexible exchange rate partly because it does not want to be seen as caving in to America’s demands, when it is in its own interest. If the world’s two leading engines of growth remain at loggerheads, everyone will pay the price.

INFLATION is always and everywhere a monetary phenomenon, said Milton Friedman, the economist who revived monetarism in the 1960s and 1970s. Everywhere, it would seem, but at today’s central banks. Since the brief monetarist heyday of the early 1980s attempts to achieve price stability by controlling money have been abandoned. Inflation targeting is the new gold standard, largely guiding even the conduct of the European Central Bank, which retains a “monetary pillar”. Jean-Claude Trichet, the ECB’s president, cited vigorous money growth after the bank raised its base rate to 4% on June 6th. But its rate-setters are at odds about how to interpret the monetary figures and the ECB’s general approach has been far from monetarist.

The backlash was rooted in the disappointments monetarism caused when it was put into effect almost three decades ago. As a way to administer some nasty disinflationary medicine the doctrine worked. The adoption in 1979 of monetary targets by Paul Volcker, chairman of America’s Federal Reserve, was a turning point in the post-war battle against inflation. In Britain, Margaret Thatcher’s espousal of monetarism eventually brought inflation down with a bump in the early 1980s.

But whatever its short-term usefulness for clamping down on inflation, monetarism proved an unreliable lodestar for steering the economy. Its central claim was that faster rates of monetary growth led predictably to higher inflation. But that held true only if the demand for money was stable. In that case, people would get rid of their excess holdings by stepping up purchases first of financial assets and then of goods and services, so driving up inflation if there was no spare capacity in the economy. In the event, the demand for money turned out to be anything but stable, as a disruptive stream of financial innovations kept shifting the amounts of money people wanted to hold.

Put another way, if the economy were to be managed through monetary targets, money had to circulate at a fixed velocity (the ratio of nominal GDP to the stock of money). In practice, that speed turned out to be highly variable. Not only that, but it was unclear what exactly the target should be, since money could be defined in different ways: narrowly, as cash and demand deposits held with commercial banks, or broadly, including savings deposits with other financial institutions. And if central bankers sought to control money, however defined, by targeting the monetary base—cash in circulation and commercial-bank reserves held with the central bank—they lost control of the short-term interest rate, which might move erratically and damage the economy.

Whereas monetarism buckled as a policy, inflation targeting has proved far more effective. Instead of seeking to control inflation indirectly, central banks aim expressly at price stability. Instead of trying to meet monetary targets, they use their own money to determine short-term interest rates. These are set to ensure a broad balance between overall supply and demand over the medium term (the next two years or so) thus keeping the economy on a path consistent with price stability. Tethering inflationary expectations is vital under this regime, which is why central-bank credibility now matters so much. If workers and firms believe that the inflation target will be hit, then short-term inflationary shocks, such as the recent jolt to energy prices, will be absorbed rather than setting off a wage and price spiral.

Whereas inflationary expectations have moved centre-stage, monetary developments have been reduced to a walk-on part. Central banks now generally see broad money as passive, responding to the economic weather, not making it. Even if money is sending a signal, it can often be intercepted by what is happening to the prices of financial assets. Indeed, Michael Woodford, an economist at Columbia University, argues that inflation can to all intents and purposes be modelled and controlled without paying any attention at all to money.

Follow the money

Has the pendulum swung too far from monetarist overkill to monetary neglect? In a recent lecture, Mervyn King, the governor of Britain’s inflation-targeting central bank, seemed to think so. He stressed that shifts could occur in not just the demand for money, but also in its supply—for example, through banks’ readiness to lend. Such developments matter because much spending is constrained by the availability of credit. Mr King highlighted two such episodes in Britain, in the early 1970s and the second half of the 1980s, when a supply-induced acceleration in monetary growth presaged a pick-up in inflation. The Bank of England has started a survey to monitor credit conditions and is researching how to tease out whether monetary expansion is stemming from changes in supply or demand.

In general, the message from money is likely to be most useful in the longer term, although developments in credit may prove helpful to central banks in the shorter term. But there is now an added complication in interpreting that message. It is no longer enough to look at what is happening to money in any one country. As financial markets become ever more linked, asset prices are increasingly set by international investors and thus reflect global monetary conditions. Indeed, there is growing unease among central bankers that the collective effect of national monetary policies may have contributed to today’s frothiness in markets round the world and that this may lead to either higher inflation or a financial crisis when bubbles eventually burst.

Money, if not monetarism, is making a comeback in the way central bankers think about and carry out policy. That is a good thing. Monetarism failed the operational test in the early 1980s. But a host of examples stretching back over the centuries bear witness to the long-term link between monetary growth and inflation. Money still matters—as it always has done.

February 22, 2009

Treasury Secretary Tim Geithner’s bank rescue — the Financial Stability Plan (FSP) — has been poorly received by the markets. My proposal last month to create brand new “good banks” with the limited taxpayer resources available is the best solution to the crisis.

One reason the Geithner plan has been poorly received is that the money isn’t there to recapitalize U.S. banks as a whole. Mr. Geithner has only $350 billion, what’s left of the original $700 billion in the previous administration’s Troubled Asset Relief Program. That’s nowhere near enough to get Mr. Geithner’s proposed Public-Private Investment Fund going on any significant scale. The scale of this investment fund — $500 billion-$1 trillion — is an empty wish unless the Treasury convinces the Congress to provide substantial additional resources to guarantee the toxic assets to be valued and bought by private investors.Moreover, Mr. Geithner’s Consumer and Business Lending Initiative only puts up one dollar of Treasury money as credit protection for every $10 dollars of Fed lending, hoping that any losses will not exceed 10% of the amount lent by the Fed (up to $1 trillion). This leverage means that the Federal Reserve system has in effect become a branch of the Treasury.

The truth is that the federal government has little fiscal spare capacity. States and municipalities have, at best, none. With the fiscal boost provided by the stimulus legislation ($787 billion, or about 5.4% of GDP over two years), the federal deficit could easily rise to 12% or even 14% of GDP for the next two years. These are numbers historically associated with banana republics headed for insolvency or hyperinflation.

The current federal debt-to-GDP ratio is around 40%, well below the above-100% level at the end of World War II. Any such ratio can be sustainable, as long as the economy is capable of generating large future government primary surpluses (that is, surpluses excluding net interest payments). But if markets judge that such future primary surpluses are not credible, they will be spooked.

Any anticipation or fear by domestic or international markets that the future will bring some combination of government default and public debt “amortization” through inflation will push up medium- and long-term nominal interest rates, inflation risk premia, default risk premia, foreign exchange risk premia and real interest rates. These responses will nullify the government’s attempt to expand the economy through increased public spending or tax cuts.

Credible larger future primary surpluses presuppose future political support for tax increases or cuts in public spending. I fear that the U.S. political system will support neither — the necessary social capital is no longer there.

The trust of the American citizen in the state is vanishingly low. Political polarization has reached the point where Democrats in Congress will kill almost any cut in public spending, and Republicans will kill almost any tax increase.

At the end of World War II, Americans willingly shouldered the burden of paying down a public debt incurred because the nation had been at war with a hated external enemy. A few years down the road, the U.S. could find itself faced with a comparable public debt burden, but incurred because the nation has been at war with itself. Solidarity, cohesion and burden sharing don’t come naturally when the defining event is not Pearl Harbor but a subprime crisis.

Given the limited scope U.S. authorities have for increasing the public debt burden without adverse asset market responses, it is best to forget about tax cuts or public spending increases. Instead, the available fiscal resources should be focused on restoring the flow of credit to nonfinancial enterprises and, to a lesser extent, to households (most of which are already over-indebted and should not be encouraged to spend more).

Rather than wasting the $1.4 trillion of public funds it would take to restore (according to NYU economist Nouriel Roubini’s estimate) the capitalization of the U.S. banking sector to its fall 2008 level, it would be better to use public money to capitalize new banks that don’t suffer from an overhang of past bad investments and loans — and to guarantee new borrowing or new loans and investment by these banks. This “good bank” model achieves this by identifying the systemically important banks that are kept afloat only by past, present and anticipated future public financial support (“bad banks”) and taking their banking licenses away.

The “stress test” proposed by Mr. Geithner for major banks (assets in excess of $100 billion) could be used to gather the necessary information to identify the bad banks. New banks, capitalized by the government (possibly with private co-financing) would take the deposits of the bad banks and purchase the good assets from the bad banks. Future government support, through guarantees or other means, would be focused exclusively on new lending and new borrowing by the new good banks and those old banks that passed the stress test.

The legacy bad banks would not be allowed to make new investments or new loans and would simply manage the inherited stocks of assets in the interest of their owners. They sink or swim on their own. If they fail, their unsecured creditors can figure out what to do with the bad assets.

When public resources are scarce, they should be concentrated not on supporting the valuations of existing impaired or toxic assets — representing yesterday’s mistakes — but on encouraging new flows of lending and borrowing, for which success or failure is still to be determined. To decouple flows of new lending from existing stocks of bad and toxic assets, a legal and institutional separation between the owners of the bad assets and the investors in the new assets is necessary. This objective is achieved by the good bank model.

The good bank approach would not be welcomed by the markets: They price the existing bad banks but not the taxpayer resources saved.

This model is better than full nationalization, because it does not require the government to trust the valuation of toxic assets implicit in the market capitalization of the banks that own them. It only requires the valuation of good assets. It is better as a recession-fighting policy because it stimulates new lending to the real economy more effectively than would an injection of capital into the existing banks, for which old toxic assets act as a tax on new lending.

The good bank model is also better from the point of view of moral hazard because it does not reward past reckless lending and investment. And it is fairer, because the losses on past failed investments are borne by those who made the bad decisions rather than by taxpayers.

Mr. Buiter is professor of European political economy at the London School of Economics and Political Science.

February 21, 2009

School of economic thought largely centred in Britain that originated with Adam Smith and reached maturity in the works of David Ricardo and John Stuart Mill.

Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, David Ricardo, Thomas Malthus and John Stuart Mill. Sometimes the definition of classical economics is expanded to include William Petty, Johann Heinrich von Thünen, and Karl Marx.

The theories of the classical school were mainly concerned with the dynamics of economic growth. Reacting against mercantilism, classical economics emphasized economic freedom. It stressed ideas such as laissez-faire and free competition. Many of the fundamental principles of classical economics were set forth in Smith’s Wealth of Nations (1776), in which he argued that a nation’s wealth was greatest when its citizens pursued their own self-interest. Neoclassical economists such as Alfred Marshall showed that the forces of supply and demand would ration economic resources to their most effective uses. Smith’s ideas were elaborated and refined by Ricardo, who formulated the principle that the price of goods produced and sold under competitive conditions tends to be proportionate to the labour costs incurred in producing them. Mill’s Principles of Political Economy (1848) gave the ideas greater currency by relating them to contemporary social conditions. Among those who have modified classical economics to reach very different conclusions are Karl Marx and John Maynard Keynes.

Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often as mediated through a hypothesized maximization of income-constrained utility by individuals and of cost-constrained profits of firms employing available information and factors of production, in accordance with rational choice theory.[1] Neoclassical economics dominates microeconomics, and together with Keynesian economics forms the neoclassical synthesis, which dominates mainstream economics today.[2] There have been many critiques of neoclassical economics, often incorporated into newer versions of neoclassical theory as human awareness of economic criteria change.